A Bumpy Road to a Familiar Low-growth Destination
PGIM Fixed Income explains why it expects to see secular factors overtake cyclical trends as already-building headwinds slow the global economy.
When investors prepare for tightening cycles, they tend to focus on how much interest rates will rise and when, putting pressure on the highest growth and highest-multiple stocks that are not currently profitable but are expected to be in the future. But as investors shift their focus on what higher rates ultimately mean for the economy, growth stocks typically regain investor favor. Growth stocks plunged into bear-market territory in the first half of 2022. While it appears most of the significant damage is done, continued volatility is expected until there is clarity around when and where rates may peak.
We are likely past peak growth for this cycle as investors grapple with the economy’s ultimate direction—a soft landing, stagflation, or a recession. In any of these scenarios, GDP growth would decline. Subsequently, stocks that can offer durable growth become more attractive and in higher demand. While the timing of when this will happen is still uncertain given some lingering wild cards, conditions should materially improve for growth stocks.
After the sharp sell-off, price-to-earnings (P/E) multiples for growth stocks have sharply contracted to below long-term averages, both in absolute terms (compared to their own historical performance) and in relative terms (compared to their performance versus value stocks). As valuations have reset, strong secular growth stocks with high consumer demand, pricing power, and robust revenues present an attractive entry point for long-term investors. While these stocks may continue to reprice in the near term based on future rate hike expectations, their ability to consistently deliver durable, profitable growth will make them more valuable to investors as economic growth prospects decline.
Longer term, we see a wide frontier for new market leaders to emerge, in sharp contrast to the broader market and its historically low share of companies posting strong revenue growth. A little more than a decade ago, one out of every two companies in the MSCI ACWI Index was growing sales at 15% or more annually. Today, it’s one in five. Given this dynamic, investors will be willing to pay more for companies with consistently stronger earnings growth because these stocks outperform over time.
In a world of scarcer growth and rising competition, the future belongs to companies that understand the transformative power of technology and successfully integrate it into their core business models. The tech-driven growth cycle is far from over, though it is evolving. Areas such as direct-to-consumer, cloud computing, digital payments, and health care innovation will be big beneficiaries of the digital revolution over the long term.
Given the rapidly shifting macro backdrop, we also think it’s important to find secular growth with grit to better navigate the near-term uncertainty. Some prudent and attractive options to boost durable growth exposure and help withstand the turning tides include:
Risks—Investing involves risks. Some investments are riskier than others. The investment return and principal value will fluctuate, and shares, when sold, may be worth more or less than the original cost. Fixed income investments are subject to interest rate risk, and their value will decline as interest rates rise. Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes, and political and economic uncertainties. Investing in emerging markets is very risky due to the additional political, economic, and currency risks associated with these underdeveloped geographic areas. Investments in growth stocks may be especially volatile. Value investing involves the risk that undervalued securities may not appreciate as anticipated. It may take a substantial period of time to realize a gain on an investment in a small or midsized company, if any gain is realized at all. Real estate investment trusts (REITs) may not be suitable for all investors. There is no guarantee a REIT will pay distributions given the inherent risks associated with the market. A REIT may fail to qualify as a REIT as defined in the Tax Code, which could affect operations and negatively impact the ability to make distributions. There is no guarantee a REIT’s investment objectives will be achieved. Diversification and asset allocation do not guarantee profit or protect against loss. Investments in in Master Limited Partnerships (MLP) and MLP-related investments are subject to complicated and in some cases unsettled accounting, tax, and valuation issues, as well as risks related to limited control and limited rights to vote, potential conflicts of interest, cash flow, dilution, and limited liquidity and risks related to the general partner’s right to force sales at undesirable times or prices. MLPs are also subject to risks relating to their complex tax structure, including losing its tax status as a partnership, resulting in a reduction in the value of the MLP investment. Many MLP investments are in the energy sector and subject to a greater degree to risk of loss as a result of adverse economic, business, regulatory, environmental, or other developments affecting industries within that sector than investments more diversified across different industries. Diversification and asset allocation do not guarantee profit or protect against loss.
The views expressed herein are those of investment professionals at Jennison Associates LLC (“Jennison) at the time the comments were made and may not be reflective of their current opinions and are subject to change without notice. This commentary is not intended as an offer or solicitation with respect to the purchase or sale of any security or other financial instrument or any investment management services. This commentary does not constitute investment advice and should not be used as the basis for any investment decision. This commentary does not purport to provide any legal, tax, or accounting advice. PGIM Investments LLC is a registered investment advisor with the U.S. Securities and Exchange Commission. PGIM Custom Harvest does not provide tax, legal, or accounting advice. This material is for information purposes only, and is not intended to provide, and should not be relied on for tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.
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